In a move that surprised the markets, the Reserve Bank decided to keep the cash rate unchanged at 3.75 per cent at their February meeting. We were no different to other market participants. In fact we wrote in the December edition of this report that we confidently expected a move when market pricing was just 30 per cent probability. By the time the RBA decision was announced, market probabilities had firmed to around 80 per cent. The result was the most surprising in many years.
Recall that on December 16 the RBA deputy governor made probably the most important speech by the RBA during 2009. The general view had been that the "neutral" level for the RBA’s cash rate was 5.5 per cent. However the deputy governor pointed out that since the global financial crisis the margin between private lending rates and the RBA’s cash rate had widened by 100bps. Certainly, in December 2007, the standard variable mortgage rate was 180bps above the cash rate, while it is currently sits at 290bps.
In defence of the banks, this widening of loan margins reflects the increase in their funding costs in domestic and offshore markets. Prior to the crisis, banks could borrow 5 year funds at around 10 basis points above the bond rate. At the peak of the crisis, spreads had blown out to 220bps over bond. With the easing in the crisis their spreads contracted to 60bps, although in recent times they have increased to around 90bps. It is unlikely that banks would be planning their funding activities on the basis that spreads retrace much more.
Now the RBA thinking is that the overnight cash rate is 75bps below the neutral level and at the expansionary end of the zone, as defined by the Deputy Governor. Compared to last September when arguably 'neutral' was still viewed as around 5.5 per cent, the gap between the cash rate and neutral has narrowed from 250bps to 75bps. That justifies a more cautious and less urgent approach to moving rates. However, with the RBA forecasting that growth will be around trend at 3.25 per cent in both 2010 and 2011, rates need to be moved back to neutral. While the Bank is forecasting growth in the region of trend, there is no justification for nudging rates above neutral, or for holding rates below neutral. The ideal "steady state" for a central bank is trend growth and neutral rates with good reason to expect inflation to be contained.
For this reason, the Reserve Bank acknowledges that "monetary policy will, over time, need to be adjusted further". Consequently we are not changing our target of 4.5 per cent for the cash rate by year’s end. We also expect rates to hold at that target for an extended period until international developments confirm to the Bank that growth in Australia is likely to exceed trend. Expectations of growth that is faster than trend justify moving rates above neutral. That is not expected to evolve until well into 2011.
Absent some huge positive shock on growth, it is reasonable to conclude that with rates getting quite close to neutral the pace of moving toward neutral will be slower than the pace of rate movements when neutral was a long way away. We are currently predicting a hike in March to be followed by May and July/August to reach 4.5%. At this point an extended pause will be signalled. The risk is that this sequence is even more drawn out. However we expect that the momentum of activity over this period will exceed trend, ensuring that the Bank sees the ongoing case for moving back to neutral.
Despite the likely growing stimulus from the external sector we see an important domestic headwind that will constrain any growth "break out” over the next year that would require the Bank to move rates above neutral. This relates to global credit conditions. We are not expecting a sustained recovery in the US economy in 2010. Ongoing uncertainty about bank and household balance sheets will continue to hamper credit markets. With Australia’s banks still sourcing half of their funding from the wholesale credit markets, funding costs are unlikely to ease from this point. Indeed, as noted above, recently spreads have widened by 30bps.
Business credit has contracted by 7 per cent over the last year. While the major explanation for this contraction is large businesses deleveraging and/or acquiring funding in the equity and capital markets, we argue that small business lending has slowed considerably. Most recent available data indicates that while lending to small businesses grew by around 8 per cent in 2008, it has contracted slightly in 2009. The February meeting statement argued "credit conditions remain difficult for many smaller businesses". With difficult and expensive funding conditions, banks are likely to continue managing asset growth. Difficult credit conditions are likely to endure.
Bill Evans is chief economist at Westpac.